The Power of Compound Interest
Typical advice in the personal finance space is to start investing as early as possible. Let the power of compound interest, also known as the 8th wonder of the world, go to work. This advice usually applies to recent college graduates to encourage them to get money into retirement accounts as soon as possible. However, what if this was taken to an extreme? Let’s see what happens when little Johnny starts investing as a baby.
The Story of Bill, Susan, and Chris
For simplicity, let’s say this window opens at the age of 25 and closes at the retirement age of 65. This would allow 40 years for your money to grow. Using the visual below as an example, you can see the power of compound interest on display. The main takeaway from the chart is Susan ends up with more money than Bill even though she only invests for a period of 10 years while he invests for 30 years. They invest the same amount of money every year and the only difference is Susan starts investing at the age of 25 (and then stops after 10 years) and Bill starts at the age of 35 and invests until retirement.
Chart assumes 7% growth rate. Souce: business insider via jpmorgan.com
Think about that for a minute. This really is a huge difference. Bill has to invest for TWENTY more years than Susan with his late start, and he will still end up with less money at retirement.
I have seen dozens of articles similar to this one associated with the above graph. However, I’ve seen very few that recommend starting to save for retirement even earlier. After additional research, the Google machine returned a few articles discussing starting investing as a baby, though similar content is rare.
Back to the graph above, let’s add someone else into the mix along with Susan, Bill, and Chris. Let’s say Johnny was born in the year 2018.
Upon Johnny’s birth, someone in his family made ONE $5,000 lump sum payment into a retirement account. For consistency. assume a growth rate of 7% and a retirement age of 65.
By making ONE payment of $5,000 when Johnny is just a tiny baby, he would have nearly $500,000 at the age of 65. Little Johnny’s money would be worth a multiple of 100 times just by placing it in an account and letting it sit there making an annual return of 7 percent.
To reiterate, Bill would have to make 30 payments of $5,000 starting at age 35 to have roughly the same amount as Johnny after making only ONE payment.
I get it that this is an oversimplified example since it doesn’t factor in inflation. For example, the purchasing power of $5,000 in the year 1982 (35 years earlier) would have been $1,946. With that being said, this still demonstrates the amazing power of compound interest. Even an investment of $1,946 would be worth nearly $200,000 at the age of 65.
I <3 Compound Interest
Why isn’t this topic discussed more broadly? Well, I’m not sure though I can speculate.
- Babies don’t read Business Insider articles (or personal finance articles in general). Therefore, the audience for personal finance articles is usually adults anywhere from recent college graduates to retirees.
- It’s weird to think about your newborn baby getting to retirement age. It just is.
- Similarly, 65 years is a really long time away and most parents only have financial responsibility for their children through college.
- Most parent won’t live to see their children turn 65. Nobody wants to think about that.
To summarize, if you have a few thousand dollars laying around and a child on the way consider throwing that money into a brokerage account and let it grow until your little bundle of joy reaches retirement age. I know that most people don’t have that kind of money available, and that really wasn’t the point of this blog post. The purpose was to show how important it is to start investing in retirement early, weather that is at age 1 or age 25. If a person takes only one thing away from the personal finance world, it should be an understanding of the power of compound interest.
Thanks for reading!